Central banks follow different paths

This is a great time to trade currencies because we are getting true differentiation across central bank policies. Enough of the old 2% inflation target stuff followed by all central banks at the same time. 

Viva la difference because this means trends. It also means that policy will have to shift over time which create turning point opportunities. 

The Fed may be shifting from a strong Quantitative Easer to a central bank which is starting to show concerns for its actions. Right now the Fed is still buying $85 billion a month, but with  the belief that there is some discussion in its minutes about alternatives, the dollar has had a strong upward trend.

The BOJ is being forced into "Abenomics" and has shown a nice decline. If this is confirmed with stronger buying of assets, the weakening trend will continue.

The BoE has mixed vote on more quantitative easing but New Governor Mark Carney is a dove. Maybe not a nominal GDP guy, but MPC is still going to focus on an easing strategy.

The ECB has shown more of mixed record. They have different problem where credit is needed in the periphery and not in the core. With slower growth, we can see more activity to expand credit in tight markets.

Some of the other G7 have stuck to existing policies but we are starting to see movement in merging markets in response to growth shortfalls. Asia is worried about Japan and will start to differentiate their policies. Brazil has a concern about inflation. Commodity currencies have concerns about an end to the commodity cycle. Australia is worried about further increase in it real exchange rate and the impact on the non-mining sector. 

2013 will be the year of monetary policy differentiation.

Back to monetary economics of exchange rates

Currency modeling at one time was very simple. The focus would be on relative inflation rates and by extrapolation monetary expansion. Sell currencies which have higher inflation or higher money expansion relative to other countries. Unfortunately, except at extremes these types of simple models did not do a good job for forecasting. Yes, during hyperinflation, these models did well. Over the longer-run, these provided a good foundation, but using monetary models for shorter-term views of under a year did not work. There was a good reason for this when monetary expansion did not differ greatly across countries. If money growth rate differences were small, the volatility of exchange rates would swamp out any relationship between money and currency prices. But times change.

Currently, monetary models can be seen as more useful. Simply put, if you fade those countries which have been stronger QE expanders, you may be do well. Sell yen. Sell sterling. Careful on euro because while ECB president Draghi said he would provide unlimited OMT, he has not put up the funds. The Fed was a strong QEer, but recent minutes suggest that the resolve is not as stronger. Note the rising dollar. 

Follow the money and use a monetary model for tilt. I do not want to be a buyer of strong QE countries especially if growth is below trend and not moving upward.

Jeremy Stein on credit bubbles

Jeremy Stein is a new member of the Board of Governors at the Fed, but he has a long history of good research on credit markets. He presented a very thoughtful speech on credit bubbles last month called "Overheating in credit markets: Origins, Measurement, and Public Response" which should be read in great detail. It calls for deeper analysis of credit markets and the potential for bubbles beyond just looking at spreads.

Stein starts with explaining the two current schools of thought that try to explain the pricing of credit. The first school is the "primitive preferences and beliefs" view while the other is the "institutions, agency, and incentives" view. The primitive preference view states that the changes in pricing for credit are associated with fluctuations in the preferences and beliefs of end users or investors. These beliefs may change in a way that will not always be rational. There can be extrapolation of good times, a change in wealth, or say a low probability weight placed on poor times. These may be a good model at explaining the technology stock bubble or bubbles in markets which have not seen declines for a long time. Here, over optimism can lead to bubbles. There is little control over the process. 

However, credit markets may be different than stock markets or general markets focused on future expectations through discounting of potential cash flow streams. Credit markets expand or contract because those suppliers of credit are willing to provide funds for lending at lower prices. This is not the same as bidding up the price of a stock. 

Put differently, it takes two to tango in the credit markets. There is a demander of credit and there is the supplier. If the supplier does not want to provide funds, credit cannot be obtained. The price of credit is also related to the incentive and behavior of the suppliers who are managers of institutions and not the end saver. Financial institutions are delegated the responsibility to provide credit, monitor the loans and make a return. In this world, the regulatory or institutional structure which create agency problems will have as big an impact on credit availability as the preferences of the buyers. 

Stein argues that changes in structure such as financial innovation, regulation, and economic environment can all impact the supply of credit at a given price;consequently, a more careful analysis has to be done on who is responsible for the creation of credit bubbles. If you believe this school, which I would agree with, the Fed and regulators have an important role in allowing credit bubbles to grow. They can create an environment that is more open to bubbles or an environment that is more controlled and less susceptible to bubbles.  The regulators should take some responsibility for the housing bubble. 

In the current environment, one that is focused on low interest rates and forcing institutions and households to hold risky assets will create a perfect bubble environment. Regulation can be structured to allow for excessive lending in housing and student loans. The demanders of credit can not be solely culpable. Similarly, banks and other financial institutions who have to hit earning targets can be a root cause for excess. Lenders set the terms of credit so even if prices do not change, banks can change terms to create a bubble environment. 

This is a very refreshing and thoughtful view to credit issues and the potential for bubbles. Lets hope that these views have a wide audience. 

Currency wars and Brazil

Remember Brazil. Its finance minister was the one who started actively using the words currency wars. Brazil was upset about the appreciation of the real and the implications for trade. 

Well now the real is again appreciating because the central bank needs to stem the rise in inflation which is above 5.5% versus a target of 4.5%. To do that, it will have to raise interest rates and cut money growth. The implication of this policy will be a stronger real. This has nothing to do with currency wars but with policies that need to be implemented on the domestic front. The fall-out will be a currency appreciation if they are effective.

The policy wars are often on the domestic front but the impact is in the price of currencies.